Every product (P) has an impact on the consumer and society. Yet it appears that what all ESG ratings fail to do is evaluate the impact on the positive and negative externalities of a company’s P. While ESG looks at operational aspects of a business, P is the part that ESG seemingly forgot.
The last 20 years have seen a shift from socially responsible investing (SRI) to sustainable investing. SRI was originally defined by values-based exclusions of companies with controversial issues (e.g., known violators of human rights), whole industries (e.g., tobacco), or even entire countries (e.g., South Africa under apartheid). SRI investors, who represented a tiny percentage of assets under management (AUM), did not want their money supporting companies and industries they felt were bad for society and the environment.
Sustainable investing is value-based in that investors have come to recognize that poor performance on material environmental, social, and governance (ESG) issues hurts financial performance, while good ESG performance contributes to strong financial results. Empirical evidence about the positive relationship between ESG performance and financial performance continues to mount.
Today, sustainable investing can be described in terms of seven strategies: (1) exclusions or negative screening; (2) norms-based screening; (3) best-in-class; (4) sustainability themes; (5) impact investing; (6) engagement and voting —(meaning, it is through engagement — and sometimes voting — that investors help companies improve their performance on the material ESG issues for their industry and strategy, which leads to better financial performance);and (7) ESG integration, which refers to the explicit inclusion of ESG factors by asset managers into traditional financial analysis. According to the most recent report from Eurosif, the fastest growing strategy is ESG integration (€4.2 trillion with a CAGR of 27 percent).
The increasing demand for quality ESG data among investors and regulators has seen an increased interest in ESG ratings agencies that provide assessments of a company’s ESG performance. Such ratings are increasingly influential in determining how capital is allocated, as they help index providers and fund managers understand vague terms such as “sustainability” when deciding whether to buy or sell a company’s stock or bond.
Assets invested sustainably have passed the $30tn mark, according to the Global Sustainable Investment Alliance, based on a classification that encompasses funds using ESG criteria to guide investing. Interest in ESG investment has grown in line with the increase of passive investing, and the number of ESG-focused equity indices has risen sharply. S&P Dow Jones Indices, one of the market leaders, today has more than 75 ESG indices.
Concretely, this means that indices and fund managers following an ESG mandate and using ESG ratings are likely to put more money into a company that performs well on material environmental, social and governance issues. However, ratings agencies many times have very different views, which results in conflicting rankings. A company can be rated “high” in general or in a specific category by one agency, and “low” by another.
Such confusion — even among the largest suppliers of ethical and ESG ratings — stems from the specific data points rating agencies use, as well as how much importance they place on the various characteristics of a company. “Aggregate Confusion: The Divergence of ESG Ratings” by Florian Berg, Julien Koelbel and Roberto Rigobon of MIT provides an intuitive analysis of why these ratings can vary so widely. They identify three main reasons for this: “Scope divergence related to the selection of different sets of categories, measurement divergence related to different assessment of ESG categories, and weight divergence related to the relative importance of categories in the computation of the aggregate ESG score.” They also “detect a rater effect, i.e., the rating agencies' assessment in individual categories seems to be influenced by their view of the analyzed company as a whole.” Regardless of their measurement methods, what all ESG ratings have in common is that they evaluate a company’s activities, inputs used, and how they operate.
A thorough ESG analysis helps shed light on issues that were formerly blind spots for investors; it helps put into perspective the costs to society and the environment a company is incurring and how — if at all — these are being managed. The traditional view is that companies will not be punished for negative externalities as long as they are adhering to all laws and regulations. This is no longer true, given changing social expectations about the role of the corporation in society. For example, the absence of a tax on carbon does not mean that shareholders — and many other stakeholders — are indifferent to a company’s carbon emissions.
While companies previously kept their ESG issues like an iceberg, hidden underwater, today ESG metrics and disclosures have enabled investors to get visbility into how well a company is managing its ESG risks and opportunities — which is important for a company’s ability to create value for its shareholders over the long term. Much like a swimmer who is given access to a new and improved diving equipment, ESG has allowed investors to see clearly below the surface, leaving in evidence that having a good or “greener” product cannot come at the expense of poor environmental, social and governance performance.
However, what a company makes is as important as how it makes it. We have become increasingly concerned about ESG, developing tools to measure and disclose impact; but in doing so, we have forgotten to take into account the positive and negative impacts products have on consumers and society at large. That is why it is important that, together with rating a company’s ESG performance, the impact of the positive and negative externalities created by P (product = goods and services) are also taken into consideration.
Every product has an impact on the consumer and society. Yet it appears that what all ESG ratings fail to do is evaluate the impact on the positive and negative externalities of a company’s P. While ESG looks at operational aspects of a business, P is the part that ESG seemingly forgot.
One factor making P more important is the 17 Sustainable Development Goals. Investors are very aware that a “good” company from an ESG perspective that is producing “bad” products that are harmful to the environment, consumers and society will ultimately face challenges to its license to operate. And these negative externalities aggregately affect the State of the World; which, in turn, affects the ability of investors to generate the expected and/or required returns.
Evaluating P will further enable investors to not only assess these externalities from an operational (ESG) standpoint, but to also consider P’s implications for long-term financial performance. Companies that are innovating to reduce the negatives and increase the positives of P will be more successful over the long run than companies doing the opposite.
By incorporating P into ESG, the invitation to rating agencies, investors, civil society, companies, customers and society at large is to look deeper into a company’s value proposition. Operational impact is important; but the impact of a company’s products are equally, if not more, important. Visibility into P will help companies improve not only how they produce, but also what they produce.